An Overview of GRATs as a Wealth Transfer Tool

Transcription

1 A Overview of GRATs as a Wealth Trasfer Tool A ceter of excellece buildig bridges from thought to actio, creatig practical, applicable strategies to help beefit you ad your family A Grator Retaied Auity Trust is a wealth trasfer tool that ca facilitate ad advace a family s objectives ad legacy by providig opportuities for tax-free, low-risk trasfers of wealth. A GRAT ca also provide a effective vehicle for successio of a closely held busiess. Wealthy idividuals typically seek straightforward, low-risk wealth trasfer tools that ca help mitigate or elimiate substatial taxatio of a family or eve a family busiess. At Hawthor, we view a Grator Retaied Auity Trust (GRAT) as oe such wealth trasfer tool that ca provide a host of beefits for wealthy idividuals, with miimal dowside risk. GRATs have several advatages, icludig: GRATs ca be structured such that o taxable gift or correspodig gift tax liability results from the ultimate trasfer of assets to family members. They ca be structured to have miimal dowside risk other tha ay applicable legal ad admiistrative costs. If the valuatio of assets trasferred to a GRAT is successfully challeged by the Iteral Reveue Service (IRS), a automatic adjustmet ca prevet ay adverse gift tax cosequeces. As a grator trust durig the auity term of the GRAT, the trasferor ca swap assets with the GRAT without icome tax or capital gais cosequeces, providig opportuities to further leverage the wealth trasfer effectiveess of the GRAT. The potetial wealth trasfer opportuity is magified i a low-iterest-rate eviromet. GRATs are sactioed by the Iteral Reveue Code (IRC). We believe GRATs represet a beeficial tool for facilitatig ad advacig a family s objectives ad desired legacy by providig opportuities for substatial tax-free, low-risk trasfers of wealth. Such trasfers ca be made i further trust to better implemet a family s overall multigeeratioal visio ad successio pla. Hawthor Istitute Residet Marty Babitz Natioal Director of Estate Plaig Also, GRATs ca provide a effective vehicle for successio of a closely held busiess, allowig the trasferor to remove substatial value from his taxable estate without taxatio or sigificat risk while retaiig cotrol over the busiess.

2 A Overview of GRATs as a Wealth Trasfer Tool GRATs are a primary wealth plaig optio that should be seriously cosidered whe preparig ad implemetig a family or closely held busiess successio pla. The Mechaics of GRATs A GRAT, govered by IRC Sectio 2702, is a irrevocable trust to which the grator trasfers assets i exchage for a fixed paymet, or auity, for a term of years chose by the grator. The term is typically measured by a fixed umber of years, but it may also be measured by the grator s life or the shorter (but ot loger) of a fixed umber of years or grator s life. 1 Upo completio of the auity paymet term, the GRAT s remaiig assets pass to the beeficiaries, either outright or i further trust. Figure 1 illustrates how a basic GRAT works. Figure 1 How a GRAT Works Step 1 Assets (cash, securities, busiess iterest, etc.) GRAT Creator (Grator) Step 2 Auity paymets, i cash or i-kid, for a defied period of time GRAT Source: Hawthor Step 3 Trust remaider (payable outright or retaied i trust for family) Beeficiary (Grator s Family) Source: Hawthor Lieal descedats, the typical iteded remaider beeficiaries of this wealth trasfer vehicle, are cosidered family members uder the IRC. 2 Therefore, the retaied auity must satisfy the defiitio of qualified iterest uder IRC Sectio 2702(b) i order to be give a value that ca reduce the taxable gift attributable to the trasfer. Auity Paymets To be a qualified iterest, the auity payable uder a GRAT must be either a fixed dollar amout or a fixed percetage of the iitial fair market value of the property as fially determied for federal tax purposes. 3 No additioal cotributios to the trust are permitted. 4 1 Treasury Regulatio (Treas. Reg.) Sectio (d)(4). 2 IRC Sectios 2702(a)(1) ad (e). 3 IRC Sectio 2702(b)(1) ad Treas. Reg. Sectio (b)(1)(ii). 4 IRC Sectio 2702(b)(1) ad Treas. Reg. Sectio (b)(4). 2 hawthor.pc.com

3 A Overview of GRATs as a Wealth Trasfer Tool This auity paymet term ca be as short as two years. Also, the auity ca be structured such that the paymets icrease as much as 20% over the precedig year s amout at ay time durig the auity term. Oly the grator ca receive auity distributios durig the auity term. 5 The auity paymets must be made at least aually. A pro-rated auity amout is required for ay short year of the GRAT (such as i the year it was created or the year of the fial auity paymet). The etire auity amout must be paid each year from icome or from pricipal, if icome is isufficiet. The auity ca be paid as late as 105 days after the aiversary of the GRAT s creatio each year, ad o later tha the date for filig the GRAT s icome tax retur (ot coutig extesios) if the required auity amout is based o the taxable year of the trust. 6 The required paymets caot be commuted (prepaid) to the grator. 7 Grator Trust Status A GRAT is treated as a grator trust for federal icome tax purposes uder IRC Sectio 673 (grator s retetio of a 5% or greater actuarial reversioary iterest i the GRAT determied at the time of the trust s creatio) or IRC Sectio 677 (retetio of icome iterest), or both. At its iceptio, the value of the retaied auity iterest i a GRAT will typically be worth more tha 5% of the value of the trust assets. I that case, IRC Sectio 673 would apply to make it a grator trust for icome tax purposes. I additio, although the retaied auity is a fixed paymet, those paymets ecessarily ecompass the icome of the trust (ad as ecessary, pricipal), causig IRC Sectio 677 to apply as well. As a grator trust, all tax items such as icome ad capital gai realized by the GRAT durig the auity term will be taxed to the grator o her persoal icome tax retur. Sice the grator is cosidered the ower of the trust assets for icome tax purposes, the actual auity distributios will ot be taxable to the grator because the passig of assets betwee grator ad grator trust for ay reaso does ot costitute a taxable evet. The grator s paymet of icome tax with respect to tax items of the GRAT as a result of its grator trust status is ot cosidered a gift by the grator to the GRAT remaider beeficiaries. 8 Accordigly, the GRAT assets grow for the remaider beeficiaries uecumbered by federal icome tax ad capital gais tax without adverse gift tax cosequeces. Most states follow federal grator trust status for state icome tax purposes as well (Pesylvaia is a exceptio). As a grator trust, the trasferor s iitial cotributio of assets to the GRAT, eve of appreciated assets, will ot result i ay icome tax or capital gais tax cosequeces. I additio, IRC Sectio 2702 does ot prohibit the trasferor from exchagig assets of equal value for assets of the GRAT. Such exchages will ot create federal icome tax or capital gais tax cosequeces durig the auity term whe the trust is treated as a grator trust. For example, durig the auity term, the trasferor could purchase assets of the GRAT for their equivalet value i cash. 5 Treas. Reg. Sectio (d)(2). 6 Treas. Reg. Sectio (b)(5). 7 Treas. Reg. Sectio (d)(5). 8 Uder Rev. Rulig , C.B. 7. 3

4 A Overview of GRATs as a Wealth Trasfer Tool Alog these lies, distributios of the required auity amout ca be made i cash or i kid (or both), without ay icome tax cosequeces to the GRAT or the trasferor. However, the GRAT trustee caot satisfy the required auity paymet by issuig a promissory ote to the grator. 9 Upo termiatio of the GRAT, the remaiig assets pass to the remaider beeficiaries, who ca be idividuals or trusts. Assets origially trasferred to the GRAT maitai the grator s icome tax basis i the trust, ad this basis carries over to the remaider beeficiaries if it is received as part of the trust s remaiig assets. Carryover basis occurs because these assets were ot subject to capital gais taxatio whe cotributed to the trust. 10 As a grator trust, the GRAT will ot be treated as a separate stockholder or as a oqualified trust for S Corporatio eligibility purposes. 11 Therefore, S Corporatio stock ca be readily trasferred to a GRAT. Valuig the Gift The value of the fixed auity retaied by the trasferor is subtracted from the value of the assets trasferred to the GRAT i determiig the value of the gift to the remaider beeficiaries at the ed of the auity term for federal gift tax purposes. This remaider iterest is a taxable gift, potetially subject to gift tax i the year the GRAT is created. We believe the reductio of the value of the grator s retaied auity i determiig the gift amout attributable to the remaider iterest passig to beeficiaries is key to accomplishig effective, leveraged wealth trasfer through the utilizatio of GRATs. If the auity amout ad term are high eough or log eough, or both, the value of the grator s retaied auity for gift tax purposes could equal 100% of the value of the assets trasferred. Thus, whe subtractig this retaied auity value from the value of the assets trasferred to the GRAT, the resultig gift is zero. This type of a GRAT is kow as a Zeroed Out GRAT. The gift of the remaider iterest is ot a preset iterest because it caot be ejoyed by the remaider beeficiaries util the ed of the trasferor s retaied auity term. Cosequetly, the aual gift tax exclusio, which oly applies to gifts of preset iterests, caot be applied to reduce or elimiate the tax liability associated with this amout. Istead, the amout of the gift attributable to the GRAT remaider iterest reduces ay remaiig lifetime gift exclusio of the trasferor, ad ay balace of the gift amout will result i actual gift tax liability. The value of the retaied auity is calculated i the moth of the gift based o the prevailig applicable iterest rate for this purpose determied uder IRC Sectio 7520 ad published mothly by the IRS. This Sectio 7520 rate fluctuates i direct relatio to chages i iterest rates o U.S. Treasury obligatios. As the Sectio 7520 rate decreases, the value of the grator s retaied iterest (which is subtracted from the value of the trasferred assets i determiig 9 Treas. Reg. Sectio (b)(1)(i). 10 IRC Sectio IRC Sectio 1361(c)(2)(A)(i). 24 hawthor.pc.com

5 A Overview of GRATs as a Wealth Trasfer Tool the value of the gift of the remaider iterest) icreases; as the Sectio 7520 rate icreases, the value of the grator s retaied iterest decreases. For example, at the August 2014 Sectio 7520 rate of 2.2%, a 10-year GRAT payig 10% of the iitial value of the assets trasferred will produce a retaied iterest value of 88.89% of the assets trasferred. Cosequetly, a trasfer of $1 millio to such a GRAT i that moth would result i a taxable remaider iterest gift of oly 11.11% of that amout, or $111,100. If, however, the Sectio 7520 rate icreased to 5.2%, the value of the retaied auity for the same GRAT would fall to 76.47% of the cotributed assets, resultig i a taxable gift of 23.53%, or $235,300. At a Sectio 7520 rate of 8.2%, the retaied auity value drops to 66.5% ad a resultig gift of $335,000, more tha three times the gift based o the curret Sectio 7520 rate. Accordigly, a lower iterest rate eviromet geerally makes GRATs more attractive (Chart 1). Chart1 History of Sectio 7520 Rate, Sectio 7520 Percetage Rate /94 6/96 6/98 6/00 6/02 6/04 6/06 6/08 6/10 6/12 6/14 Source: Hawthor The Sectio 7520 rate is equal to 120% of the midterm applicable federal iterest rate for itrafamily loas determied uder IRC Sectio 1274, rouded to the earest.20%. The Sectio 7520 rate for August 2014 was 2.2%. Geerally, if the overall ivestmet rate of retur o the GRAT assets exceeds the Sectio 7520 rate used i determiig the required auity amout ad correspodig projected remaider amout, the GRAT will geerally be successful because assets i excess of the actuarially projected remaider amout (which is the measure of the gift amout) will be passig to the beeficiaries. Cosequetly, the Sectio 7520 rate is ofte referred to as the hurdle rate because it represets the threshold for a rate of retur o the GRAT assets that will result i a successful wealth trasfer. 35

6 A Overview of GRATs as a Wealth Trasfer Tool Cocers While there are sigificat beefits associated with a GRAT, careful plaig is also eeded to avoid what we thik are some potetial pitfalls. Mortality Risk Estate Tax Iclusio If the trasferor dies durig the term of the required auity paymets, the all or a portio of the GRAT assets will be icludible i his taxable estate. 12 The estate would iclude assets of a trust to which a grator has made a trasfer while retaiig a right to icome from that trust which has ot eded at the time of death. Although the retaied iterest is a auity rather tha specifically icome, the IRS specifically treats the retaied auity as costitutig the retetio of the right to icome for purposes of IRC Sectio 2036(a)(1). 13 IRC Sectio 2039, which geerally icludes the value of auities held at death, ca be excluded as a mechaism for estate iclusio; retaiig a iterest i a auity from a trust is ot ecompassed by IRC Sectio Although some advisors might assert that all of the assets of a GRAT are always icludible i the taxable estate should the grator die prior to the ed of the auity term, oly the portio of the GRAT assets ecessary to provide the auity paymet without reducig or ivadig pricipal are icludible i the decedet s taxable estate. 15 Example 2 i Treasury Regulatio Sectio (c)(2)(iv) provides that the icludible amout is calculated by dividig the auity amout by the Sectio 7520 rate i effect o the grator s date of death. This formula must be used regardless of whe the grator dies durig the retaied auity term. I may situatios, this formula may evertheless cause all of the assets of the GRAT to be icluded i the grator s taxable estate. For example, assume a grator establishes a GRAT i August 2014 by trasferrig $1 millio ad retaiig a aual auity of $137,690 for eight years based o the 2.2% Sectio 7520 rate. After receivig six aual auity paymets but prior to receipt of the last two years auity paymets, the grator dies. If the Sectio 7520 rate at the time of the grator s death has icreased to 4.0%, the amout of the GRAT assets icludible i the grator s estate would equal $137,690 (the aual auity paymet) divided by.04 (Sectio 7520 rate at death), or $3,442,250. Uless the aual ivestmet retur o the assets, et of the auity paymets, was at least 32%, this figure would equal or exceed the value of the GRAT assets at that time. Thus, all of the GRAT assets would be icluded i the grator s taxable estate. Cosequetly, the trasferor s age, health, related factors, ad geeral risk of death i ay year should be take ito accout i determiig the legth of the retaied auity term. The shorter the term selected, the higher the correspodig required aual auity paymet to accomplish the same actuarial value of the retaied auity i determiig the value of the remaider for federal gift tax purposes. 12 IRC Sectio 2036(a)(1). 13 Treas. Reg. Sectio (c)(2). 14 Provided for uder Treas. Reg. Sectio (e). 15 Treas. Reg. Sectio (c)(2). 62 hawthor.pc.com

7 A Overview of GRATs as a Wealth Trasfer Tool Valuatio Issues IRC Sectio 2702 cotais the specific requiremets for GRATs as outlied above. As log as these requiremets are cotaied i the GRAT documet ad adhered to i its admiistratio, there is geerally o risk of IRS challege to the GRAT itself. However, a potetial challege is proper valuatio of the assets trasferred to the GRAT. For example, if a grator iteds to create a Zeroed Out GRAT ad trasfers assets she values at $1 millio, a specific correspodig auity amout would be set based o the Sectio 7520 rate i the moth of the GRAT s creatio ad the selected legth of the auity term. If, however, the IRS values those assets at $1.5 millio, the auity amout would have bee required to be 50% higher each year i order to zero out the GRAT ad elimiate ay taxable gift amout attributable to the projected remaider iterest. As a result, the deficiet auity amout would result i a taxable gift for federal gift tax purposes. Treasury Regulatio Sectio (b)(2), however, allows for a automatic adjustmet upward of the required auity amout i such cases so that o adverse uiteded federal gift tax cosequeces result. Of course, the icreased auity amout will ultimately reduce the amout of the remaiig assets passig to or for the remaider beeficiaries. Geeratio Skippig Tax Issues The Geeratio Skippig Trasfer (GST) tax applies to trasfers to skip persos, which geerally iclude gradchildre or subsequet geeratios of the trasferor, or trusts for such idividuals. The GST tax applies to gifts or bequests i additio to ay gift tax or estate tax liability at a rate of 40%. A GST tax exemptio equal to the lifetime exclusio (curretly $5.34 millio per perso, idexed for iflatio) is available to cover such trasfers. If GST tax exemptio is allocated to all of the assets of a trust, the the assets of that trust ad their future appreciatio ca be etirely exempt from GST for the trust s duratio. This would apply as log as o subsequet gifts or bequests are made to the trust that are ot covered by additioal allocatio of GST tax exemptio. (For more o the GST tax, see the Jue 2013 Hawthor white paper, The Family Opportuity Trust, Part II: Leveragig the Trust.) Oe limitatio o the wealth trasfer potetial of GRATs is the estate tax iclusio period (ETIP) rule applicable to GRATs uder IRC Sectio 2642(f). Uder this provisio, a trasferor s GST tax exemptio caot be allocated to the remaider iterest i the GRAT while assets of the GRAT are icludible i the trasferor s taxable estate uder IRC Sectio Accordigly, GST tax exemptio caot geerally be applied to the GRAT remaider iterest util the close of the trasferor s retaied auity term. The full amout of the actual remaiig assets of the GRAT at the ed of the auity term would be subject to GST tax ad require allocatio of GST exemptio to that amout i order to avoid such tax, if the remaider passes to or for GST-taxable beeficiaries such as gradchildre. 37

8 A Overview of GRATs as a Wealth Trasfer Tool As a example, assume $1 millio is trasferred to a Zeroed Out GRAT. At the close of the grator s retaied auity term, $500,000 of assets remai. The measure of the taxable gift for federal gift tax purposes is zero because the value of the gift for this purpose is determied at the creatio of the GRAT whe the actuarially projected gift of the remaider iterest is zero. For GST tax purposes, however, the amout subject to GST tax, ad thus requirig allocatio of GST tax exemptio to avoid impositio of GST tax, is $500,000, the actual value of the assets at the close of the auity term. Although there is geerally o leverage or beefit to utilizig GST tax exemptio with GRATs, there are potetial work-arouds to allow for effective geeratioskippig plaig for GRATs. These are discussed i the Hawthor Istitute paper, Optimizig GRATs. Note that a gradchild or gradchildre could be the remaider beeficiaries of a GRAT without GST tax cocer or eed for GST tax exemptio allocatio whe the grator s child, who is paret of the subject gradchild or gradchildre, is deceased at the time the GRAT is created. This IRC provisio treatig such gradchildre as beig oly oe geeratio removed from the trasferor (that is, takig the place of their deceased paret), ad thus ot a skip perso for GST tax purposes, is kow as the predeceased paret exceptio. 16 Reimbursemet of Grator for Icome Taxes For flexibility purposes, grators ofte request that the GRAT trustee have the authority to reimburse the grator for icome taxes attributable to the tax items of the GRAT that pass to the grator s persoal icome tax retur, based o the GRAT s grator trust status for icome tax purposes. Treasury Regulatio Sectio (b)(2) treats availability of trust assets to discharge a legal obligatio of the decedet (such as debts, icludig taxes) as a retaied right to ejoymet of the property causig iclusio of the assets of the trust i decedet s taxable estate. Reveue Rulig , however, states that the grator s mere retetio of a discretioary beeficial iterest aloe is ot sufficiet to cause estate iclusio uder IRC Sectio 2036(a)(1) if the grator s creditors caot be satisfied from the trust assets, as log as there is o uderstadig or arragemet betwee the grator ad trustee regardig the exercise of discretio for the grator, ad the grator does ot retai the power to remove ad replace the trustee. We do have oe cocer, however. Reveue Rulig also held that if either the trust documet or state law required (rather tha permitted i the trustee s discretio) that the grator be reimbursed for tax paid o behalf of the trust, the 16 IRC Sectio 2651(e). 28 hawthor.pc.com

9 A Overview of GRATs as a Wealth Trasfer Tool this would costitute the right to have trust property used to discharge a legal obligatio of the grator. This could cause iclusio of the trust assets i his taxable estate. 17 While a GRAT documet ca readily be drafted to permit but ot require the trust to reimburse the grator for taxes paid with respect to the trust to avoid this aspect of the rulig, the provisios of state law o this issue caot be cotrolled. Alog these lies, there is a questio whether the law of some states (such as Pesylvaia) requires a trust to reimburse the grator for taxes she pays o behalf of the trust. 18 New York, o the other had, provides specifically by statute that a creditor of a grator caot reach trust assets based solely o the trustee s discretioary power to reimburse the grator for tax liability with respect to icome of the trust. 19 Delaware law is equally clear o this poit. Ideally, icludig a reimbursemet provisio would occur if goverig state law was clear, such as i New York or Delaware, that the discretioary reimbursemet provisio would ot cause iclusio of the assets i the grator s taxable estate. Federal Proposals Affectig GRATs The 2015 federal budget, cosistet with prior years budgets, proposes the followig provisios to restrict GRATs: a miimum auity term of 10 years; decreases i the auity amout durig the GRAT term prohibited; ad a requiremet that the actuarial remaider at the outset of the GRAT be greater tha zero. The last proposal above would elimiate Zeroed Out GRATs. Neither the 2015 budget or ay previous budget, however, states the amout or percetage by which the miimum required projected remaider would have to exceed zero. Oe dollar is greater tha zero; accordigly, without some required miimum remaider, Zeroed Out GRATs would remai viable as a practical matter. Perhaps if this proposal is take up by Cogress, we believe the bill could propose some actual threshold miimum actuarial remaider amout. A possible miimum might be 10% of the iitial value of the GRAT assets, which is cosistet with the requiremet for Charitable Remaider Trusts. I our opiio, the elimiatio of Zeroed Out GRATs i some sigificat sese (such as through a 10% miimum remaider requiremet) ad the elimiatio of GRATs with terms shorter tha 10 years would dramatically ad egatively affect the utility of GRATs ad several of the methods for optimizig them discussed above. Ay or all of these proposals, if eacted, would, pursuat to the budget proposal, take effect for GRATs created after the date of their eactmet. 17 This aspect of the rulig was based o IRC Sectio 2036(a)(1). 18 See Frech Trust, 23 Fiduciary Reporter 296 (Philadelphia Couty Orphas Court 1963) ad Mathay Trust, 1 Fiduciary Reporter 2d 96 (Motgomery Couty Orphas Court 1981) regardig Pesylvaia law o this issue. 19 New York Estates, Powers ad Trusts Law Sectio 7-3.1(d). 39

10 A Overview of GRATs as a Wealth Trasfer Tool I additio, the 2015 budget would geerally treat the portio of assets i a trust received i a swap trasactio betwee a grator ad a trust that is a grator trust for icome tax purposes with respect to the grator, as subject to federal gift or estate tax. This proposal, which would be effective for such trasactios after the date of its eactmet ito law, would further erode some of the plaig opportuities available with GRATs, ad GRAT remaider iterests, as described above. The possibility of these proposed chages places some sese of urgecy upo establishig GRATs for idividuals ad families where such a wealth trasfer strategy ad related plaig opportuities fit their plaig objectives. Coclusio We believe GRATs represet a miimal-risk wealth trasfer tool with the potetial for substatial reductio of oe s taxable estate with little or o gift tax liability or use of lifetime gift exclusio. I additio, the curret low-iterest-rate eviromet geerally favors GRATs, makig them more effective tha whe higher iterest rates are i effect. The substatial beefits, without detrimets, of GRATs as provided for i the Iteral Reveue Code have made them a target for adverse legislative chages. Accordigly, idividuals seekig to egage i family wealth trasfer should cosider ad perhaps implemet a GRAT or GRATs i the ear term. Several related strategies exist for further leveragig wealth trasfer with GRATs. These strategies are examied i the Hawthor Istitute paper Optimizig GRATs. 210 hawthor.pc.com

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